The Financing of Government Securities Dealers, June 1964--PDF

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					                                           FEDERAL RESERVE DANK OF NEW YORK                                                      107

                       The Financing of GovernmentSecurities Dealers*

   The United States Government securities market is one           and borrowers adjust their liquidity positions. In addition,
of the key financial markets in this country. In this mar-         it redistributes bank reserves, provides a link between sec-
ket, the United States Treasury raises new money for               tors of the money market, and helps transmit the effectsof
Government operations and refinances outstanding securi-           monetary policy throughout the country. Yet, the dailytask
ties. The Federal Reserve uses the market as the vehicle           of financing dealer inventories of Government securities is
for its conduct of open market operations, one of the              carried out so smoothlyand unobtrusively that few persons
major instruments of monetary policy. And many groups              are aware of the significance of these financing arrange-
of private investors use the Government securities market          ments for the money market. To provide some perspective
as a means of making adjustments in their liquidity posi-          on the impact of dealer financingon themoney market, this
tions and as an outlet for investment funds. In 1963, trad-        article describes dealer financing arrangements and the
mg volume in United States Government securities totaled           majorsources of funds for dealers in the early 1960's.
$429 billion (excluding direct acquisitions of new issues             The statistics used include all short-term financing of
from the Treasury and redemptions of Treasury issues,              United States Government and Federal Agency securities
which also run in the hundreds of billionsof dollars).             arranged by bank and nonbank dealers who report to the
   The bulk of the transactions in this market is effected         MarketStatisticsDepartment of        th Federal Reserve Bank
through a group of dealers (including both banks with
                                                                   of New York.1 These statistics cover collateral loans (a
dealer departments and nonbank dealer firms) who make              typeof financing under which the dealer retains title to the
markets by buying and selling securities for their own             securities but transfers them to the lender or his agent as
accounts. For such a market to function effectively,               collateral for the term of the loan), repurchase agreements
dealers must be willing and able to maintain large inven-          (an arrangement under which the dealer actually sells the
tories of securities and thus to accommodate customers             securities but simultaneously commits himself to re-
when there are no immediate offsetting transactions. With          purchase them at a price fixed at the time of the initial
Government securities as collateral for loans, the dealers         transaction), and "own bank funds" (money allocated to
are able to rely very heavily on short-term borrowings to          the dealerdepartment of a dealerbank by the bank itself).
finance their inventories. Since the nonbank dealers' posi-           En response tochanges in the relativecost andavailability
tions arc carried largely on borrowed funds, the cost of           of funds, the nonbank Government securities dealers shift
financing is a major determinant of profits. The search for        their financing among a wide variety of lenders, including
relatively cheap sources of financing is, therefore, a key         New York City banks, other banks, nonfinancialcorpora-
aspect of the dealers' daily work. In fact, without access to      tions, agencies of foreign banks, state and local govern-
a country-wide and financially attractive supply of bor-           ments, insurance companies, and a number of other finan-
rowed funds, the dealers' ability to carry an inventory and        cial institutions. In addition, the Federal Reserve makes re-
make markets in Government securities would be seriously           purchase agreements with nonbank dealers when open
impaired and the Government securities market could not            marketpolicy considerationsmake suchcontracts desirable.
function as it doestoday.                                          Bank dealers, on the other hand, tend to rely primarily on
   A large portion of the dealers' borrowings are arranged         internal funds but may also utilize repurchase agreements
on a day-to-day basis. The daily routine of arranging
new loans and repaying outstanding loans has several
important consequences. It influences (and is in turn
influencedby) the terms on which banks and other lenders           1Since mid-1960 the Government securities dealers have been
                                                                 cooperating in a statisticalprogram that has included the daily re-
                                                                 porting of their positions, financing, and transactions. Some of the
                                                                 dealers had previouslyreported to the Securities Departmentof the
                                                                 New York Federal Reserve Bank. Most of (be statistics in the article
    LouiseFreeman had primary responsibility for the preparation arc releasedregularly by the Federal Reserve Bank of New York
of this article.                                                 and publishedin thc Federal Re.lerve Dulletin.
108                                                                  MONTHLY REVIEW,JUNE 1964

to attract low-cost funds from corporations and other
lenders, as well as to accommodate theircustomers by pro-
                                                                                               flNANflNC OF GOVERNMVNT sEcuRmEs
                                                                                                       1961-63; annual averages of daily data
viding them with an investment for tetnporarily idle funds.                                                            Anesrnt outstandin       Share of total borrcwloo
   The total volume of the dealers' daily financingrequire-     Distriboliojiof fimneing
                                                                                                                       (cilliona of dollars)            titer cent)
ments is large and highly volatile. Total dealer financing                                                            1961    1962      1963    1961      1962        1%)
outstanding grew from a daily average of $2.7 billion in
1961 to $3.6 billion in 1963. In addition, the actual daily Total                                                    2,712    3,364     3.535   100.0     100.0       100.0
level of dealer financing ranged from a low of $1.7 billion
to a high of $5.4 billion between September 1960 and By sourofftnds:
December 1963. These sizable short-run variations in total   New York City basiks                                      671      590      941    24.7       26.5       26.4
                                                                                         Other banks                   612      636      763    22.6       19.5       21.4
                                                                                         Nonfinancial corporations   1.171    1.462     1,467   43.2       43.5       41.2
                                                                                         Federal Reserve                49       59      114      1.8       1.8        3.2
                                                                                         Other?                        208     297       274     7-7        8.8        7.7
                                                                                       By type ofInstrument:
                                                                                         Repurchase agreements       1,716   2,132     2.242    63.3       63.4       63.0

                                                                                          short!                      901    1,065     1,305    33.1       31.7       36.8
                                                                                          Longt                       815    1,067       934    30.1       31.7       26.3

                                                                                         Collateralloans and
                                                                                         own bank fund't              996    1,232 1.316        36.7       36.6       37.0

                                                                                       Bytypeof dealer:

                                                                                         flankil                               605       714    18.5       18.0       20.1

                                                                                         Nonbank                     2:09    2.759     2,844    81.5       82.0       80.0

                                                                                         Nose: Becauseof rounding,tiguses do notnceessazilyadd tototals.
                                                                                           Includes slsort•term financing for United Stales Government and
                                                                                             Federal Agency secualtics.
                                                                                         t Includes mainly Mate and local governments, agencies of foreign
                                                                                             banks, insurance companies, and other financial institutions.
                                                                                            Repurchase agreementsmaturing InOiteen days or Iris.
                                                                                         § Repurchaseagreementsmaturingin sixteen days or more.
                                                                                           Includes funds raised through repurchase agreements by dealer de-
                                                                                             partments to lirtance their positions as well as "own bank funds".

                                                                                       financing are illustrated in the top panelof the accompany-
                                                                                       ing chart,although the chartin fact smoothsthe fluctuations
                                                                                       since monthly averages of daily data rather than actual
                                                                                       daily figuresare plotted. The variation in total financingthat
                                                                                       is shown in the chart reflects increases and decreases in
                                                                                       dealers' positions, mainly in Treasury bills.
                                                                                          As a result of the sharpchanges in total dealerfinancing
                                                                                       and the constant search for lower costs by dealers and for
                                                                                       better yields by lenders, the sources of dcalcr financing
                                                                                       change from day to day. The greatcst variations have
                                                                                       occurred in financing supplied by New York City banks;
                                                                                       theactual daily lcvel of such financinghas ranged from $2.3
                                                                                       billion to $179 million. On the same basis, financing from
                                                                                       nonfinancialcorporations also has fluctuated a good deal—
      Not, Ilnor.cing oronIdad by ho Fod.rniRosom and.ia,.ttoa.oq, land.,,isasdudad.
                                                                                       from as much as $2.2 billion a day to as little as $620
       Tb.eAton,owppt'*dby     that,tour" did no'ncnd$331,ü3ooand$420mlItio
                                 .hoain ha chart,                                      million, while borrowing from banks outside New York
       taspcctiveIy,inany aonlh
                                                                                       City has fluctuated between $1.5 billion a day and $174
                                          FEDERALRESERVE BANK OF NEW YORK                                                       109

million. This variation in the three largest sources of funds    Before the mid-1950's, New York Citybanksmadecol-
for dealers is also reflected in the monthly averages of      lateral loans to nonbank dealers only in Clearing House
daily data shown in the chart.                                funds, but three of the five major New York City banks
    In the early 196O's, however, the short-run shifts        making dealer loans now regularly extend both Federal
among various sources of financing have tended to even        funds loans and ClearingHouse loans. In recent years, Fed-
out over a year. During the 1950's there had been a           eral funds loans outstandinghave accounted for over halfof
gradual shift in dealer financing away from New York          the total collateral loans of New York City banks. More-
City banks to other lenders and away from loans to re-        over, the daily change in Federal funds loans usually has
purchase agreements, as dealers gradually developed new       been much larger than the change in Clearing House
sources of financing. This process was largely completed      loans. Similarly, agencies of foreign banks in New York
by the end of the decade. Thus, when annual averages of       City make dealer loans in both Federal funds and Clearing
daily data are calculated, the distribution of dealerfinanc-  House funds. On the other hand, virtually all loans or
ing by source, by type of instrument, and by type of          repurchase agreements with other lenders holding deposits
dealer is found to have been relatively stable during 1961-   in New York City are made in Federal funds. Almost
63 (sec table). Among the major sources of funds, non-        invariably, borrowings from out-of-town lenders (both
financial corporations provided over 40 per cent of the       banks and corporations) arc Federal funds loans, because
dealers' financing requirements in cach of the three years;   the funds are transferred the same day over the Federal
the New York City banks furnished roughly 25 per cent;        Reserve wire facilities. Repurchase agreements with the
other banks supplied around 20 per cent; and the Federal      Federal Reserve alwaysinvolveFederal funds.
Reserve and otherlenders contributed the rest. In eachyear,      The use of both Federal funds loans and Clearing House
repurchase agreements accounted for about five eighths (or    loans arises from the fact that both types of payment are
$1.7 billion to $2.2 billion per day) of all funds raised by  used in United States Government securities transactions.
dealers, while collateral loans and internal funds of bank    The more recent practice of paying for short-term securi-
dealers together averaged about three eighths (or $1.0        ties in Federal funds arose in part because it facilitates im-
billion to $1.3 billion per day). About four fifths of the    mediate adjustments in bank reserve or portfolio positions.
total represented financing of nonbank dealers and one        Naturally, it is convenientfor a dealer to do his financingby
fifth the financingof bank dealers.                           the same method by which the securities transaction is
                                                              settled. Nevertheless, it is possible to use a Clearing House
                                                              loan to finance purchases settled in Federal funds (and
              DEALER FINANCING UN 1963                        conversely). This usually involves the dealerin a purchase
                                                              and sale of Federal funds as well as in the loan arrange-
   In deciding where and how to finance his position, a ment, but sometimes actual or expected rate differentials
dealer has to consider several characteristics of the loan. between rates on Clearing House and Federal funds loans
What type of funds will be provided? When will the loan or between present and future rates on Federal funds make
mature? Will he have the right of substitution of collateral? this extra work worthwhile.
What will it cost him?                                            MATURITY. Dealer loans also differ with respect to
   TYPE OF MONPY PROVIDED. There are two types of money maturity. Most loans and some repurchase agreements
that Government securities dealers can borrow: Federal (particularly repurchase agreements with banks outside
funds and New York Clearing House funds. When a New York City) are day-to-day or demand obligations
dealer obtains a Federal funds loan, he receives a draft on that have no specified maturity and can be terminated at
the reserve balances of the lender's bank at its Federal
Reserve Bank. A transfer of reserve balances occurs on
the same day as the loan, and the dealer therefore can use
the money immediately. If the dealer obtains a loan in             In order to finance a Federal funds purchase with a Clearing
                                                              Housc loan, the dealer must buy               funds with the Clearing
Clearing  House funds, on the other hand, he receives a House checkreceivedin the loan. Federal words,he exchanges the
                                                                                                   In other
certified check on a New York City bank. This cheek Clearing House check for another New York City hank's draft on
must be presented at the New York Clearing House, and course, in this caseat the Federal Reserve for the Federal funds at
                                                                                                            Rank of New York. Of
                                                              its reserve balance
                                                                                   the dealer has to pay
                                                                               as well as for the dealer
payment out of reserve balances of the drawcc bank is the market rate,offset when the loan is loan. Thisextra cost, how-
not effected until the next day. Hence, the funds cannot ever,hasusually                                repaid, if the Federal funds
                                                              rate     not changed. When the dealer sells the securities,he nor-
be used until that day, except in transactions requiring mally receivesFederal funds, which he alsosells; and he uses the
settlement in Clearing House funds.                           Clearing House check received in the sale of Federal funds to repay
                                                              the Clearing House loan.
    110                                                   MONTHLY REVIEW,JUNE 1964

    any time by either borrower or lender. The New York On any given daythe rates may vary from bank to bank, and
    City banks, however, rarely make use of this right on occasionally a bank may change its rate during the day.
    collateral loans, preferring instead to discourage loan These rates are available to nonbank Government securi-
    renewals by raising their loan rates. Other lenders and ties dealers on loans secured by United States Government
    the dealers do reduce demand loans at their discretion, securities or by other collateral (such as Federal Agency
    although the other party to the transaction is usually securities, negotiable time certificates of deposit, and
    given notice early in the day.                          bankers' acceptances) as stipulated by each bank at any
        Collateral loans with spccffied maturities of several days           given time.
    are sometimesavailable, especiallyduring Treasury financ-                   The rates charged by the New York City banks are
    ings; and many repurchase agreements (particularly those                 usually higher than the rates available from other lenders.
    with corporations) have specific maturity dates ranging                  Rates charged by these banks also are frequently above
•   from one day to several months. The statistics on repur-                 the yield the dealers are earning on the collateral, so that
    chase agreements,however,provide only two maturity cate-                 dealers have a so-called "negative carry". This situation
    gories, those with a current maturity of fifteen days or less            also occurs occasionally,but to a lesser degree, with regard
    and those maturing in sixteen days or more.3 Long repur-                 tofunds obtained from other sources.
    chase agreements—those with sixteen days or more to                         The rate on funds obtained through repurchase agree.-
    maturity—have constituted between one quarter and one                     ments with private lenders is a matter of negotiation
    third of total dealer financing during the three complete                between dealer and lender. Rates are not posted, nor are
    years for which such data are available (see table). The                  they published anywhere. Both lenders and dealers,
    rest of dealer financing, consisting of short repurchase                 however, can get some idea of the market by "shopping
    agreements, collateral loans, and own bank funds, has al-                around", and the dealers also get a feel for the market as
    most always had a maturity of fifteen days or less. Most of              lenders accept or reject the rates they offer. Moreover,
    the long repurchaseagreementshave beenwith nonfinancial                   the money market framework within which rates on
    corporations; a few have been with banks and other lenders.              repurchase agreements are set—the Federal funds rate,
       The Federal Reserve makes repurchase agreementswith                   the dealer loan rates at New York City bunks, and yields
    nonbank dealers for specifiedperiods, ranging from one to                on Treasury bills—is known to all market participants.
    fifteen calendar days. United States Government securi-                     A nonbank Government securities dealer can usually
    ties which mature in two years or less arc acceptable col-               satisfy his credit needs from the New York City banks
    lateral for such contracts, and the dealer cannot substitute             as a group at their posted rates, although the volume of
    collateral.' The Federal Reserve dctermines the original                 loans he can obtain from any one bank will be limited.
    maturity of the repurchase agreement; either party may                   Accordingly, the maximum rate a nonbank dealer would
    terminate the contract before maturity. In practice, the                 pay tij another lender on a demand, or one-day, repur-
    Federal Reserve seldom exercises its right to terminate re-              chase agreement depends on the dealer loan rates at New
    purchase agreements before maturity. In contrast, other                  York City banks minus the additional costs involved in
    lenders ordinarily do not allow the dealers to terminate                 obtaining the loan elsewhere(see section on "OtherCosts").
    repurchase agreements with specifiedmaturity dates before                For a bank dealer, the maximum rate would usually be the
    maturity, but substitution of collateral may be permitted.               discount rate. The minimum rate a dealerwould find is, of
        itams. The basic rate in the cost structure of nonbank               course, the yield the lender could obtain on alternative
    dealers is the rate (or rates) on collateral loans at New York           investments. For commercial banks this alternative is the
    City banks. Every morning eachof the five New York City                  sale of Federal funds. For business corporations there are
    banks regularly making dealer loans posts at least two                   few, if any, suitable alternative one-day investments; but
    dealer loanrates: one for renewals and one for newloans.5                for slightly longer periods they can buy short Treasury
                                                                             bills, finance company paper, or similar securities.
                                                                                Within these limits, the rates paid by a dealer on
       3The dividingline between shortand longrepurchaseagreements           repurchase agreements of the same maturity may differ
    is arbitrary; this division was selected in part becauseall repurchase   on any given day because of the size of the loan, the
    agreementswith the Federal Rcscrvc mature in fifteendays or less.        lender's willingness to accept longer term collateral or to
       The Federal Reserve also makesrepurchase        agreements (with      allow substitution of collateral, the time of day the loan
    a maximum maturity of fIfteen days) with nonbank dealers on              is arranged, or the other business the lender has to dis-
                                          or less.
    bankers' acceptances maturingin six months
       Sometimes a bank may post two rates for new loans, one for
                                                                             tribute. From one day to the next, the relationship of
    Clearing House loans and the other for Federal funds loans.              the rate on day-to-day repurchase agreements to the basic
                                        FEDERAL RESERVE BANK OF NEW YORK                                                Ill

money market rates will vary with the dealers' financing       transactions through a clearing bank. This bank accepts
requirements and the supply of funds available from            and makes payment for the securities purchased by the
lenders. In periods when the dealers expect the costs of       dealer and, in effect, makes a temporary (or day) loan
day-to-day money to remain unchanged, the rate offered         to the dealer until he is able to arrange overnight financ-
for a repurchase agreement of a few days' duration may         ing. If the dealer arranges a Clearing House loan when he
be the same as that for a demand, or one-day, agreement.       in fact needs Federal funds, the clearing bank may also
   Rates on longer repurchase agreements with specific         provide him with the necessary Federal funds. Similar
maturity dates—agreements that are made primarily with         services arc provided when the dealer sells or refinanccs
corporations—are usually based on the yield on Treasury        securities. Generally, the fee for these services is a flat
bills with a maturity close to that of the repurchase          dollar amount per million dollars of securities delivered.
agreement. The rate on a long repurchase agreement             This clearance fee—which is imposed each time securities
would almost invariably be lower than the dealer's             are delivered—appliesto outright sales, repurchase agree-
yield on the bills serving as collateral, since the dealer     ments, and some collateral loans with out-of-town banks,
would prefer to finance securities involving a negative        but not to collateral loans with New YorkCity banks. For
early on a day-to-day basis so that they can be sold           any one dealer the fee varies with the type of securities
readily. The spread between the rate on the repurchase         involved (lowest for bills and highest for bonds). The
agrecment and the return on bills of comparable maturity       fee also varies among dealers, essentially because of differ-
mainly depends on the yield accruing to the dealer on          ences in the cost of servicing the accounts; dealers with
the collateral, his expectations regarding yields and bor-     the largest dollar volume of trading pay the leastper dollar
rowing costs, the supply of loanable funds, and the            of transactions. In the case of a one-day repurchase
dealer's financing requirements. If the dealer is not          agreement or loan these fees add a substantial amount to
allowed to substitute collateral, the rate paid the lender     the cost of financing, but they decline as a percentage of
would probably be lower thanotherwise.                         carrying costs, of course, as the maturity of the repurchase
   The rate charged by the Federal Reserve on repurchase       agreementincreases.
agreements with Government securities dealers is usually          In all financing arrangements, except for the occasional
equal to the discount rate—it may not be lower than the        unsecured loan, the dealers transfer collateral or securities
discount rate of the New York Reserve Bank or the issu-        to the lenders. In fact, the dealers usually provide the
ing rate on the latest issue of three-month bills, whichever   lenders with collateral valued at more than the amount of
is lower; there is no prescribed maximum.6A rate other         the loan—i.e., theyprovide margin—and thus tie up some
than the discount rate of the Federal Reserve Bank of          of their capital. Margin requirements on collateral loans
New York has, in fact, been charged on only fifty-three        vary among banks, but at all banks they increase with the
days between 1955 and 1963.                                    maturity of the collateral. On loans at New York City
   The rates dealers pay on collateral loans with domestic     banks, for example, the margin is zero or close to zero on
commercial banks outside New York and New York agen-           the shortest securities, while even on the longest bonds the
ciesof foreign banksare somewhat below rates charged by        dealers rarely put up margin of more than 3 per cent.
New York City banks, but are probably higher than rates           The margin provided to private lenders on a repurchase
on repurchase agreements. The procedure varies for charg-      agreement probably tends to be less than that on collateral
ing dealer departments of commercialbanks for ownbank          loans with New York City banks. Indeed, some corpora-
funds and for the proceeds from repurchase agreements.         tions value Treasury bills at par for repurchase agree-
Such charges, if allocated, probably would not exceed the      ments, which in effect gives them a negative margin since
Federal Reserve discount rate.                                 bills arc discount securities and trade below par. Other
   OTHER COSTS. In addition to interest, the dealers have      corporations require no margin and value bills at market
a number of other expenses in arranging financing, includ-     prices. When margin is provided, it tends to increase with
ing costs of locating funds and clearing charges. Usually      the maturity of the security sold under repurchase agree-
they also have to meet margin requirements.                    ment. The Federal Reserve always requires margin for
  Most of the nonbank dealers channel their securities         repurchase agreements with dealers.

                                                               REPURCHASEAGREEMENTS WITH CORPORATIONS
  6 Forthe latest published reference,see the "continuing authority"
                                                                       Nonfinancial corporations, one of the most important
directiveof theFederal Open Market Committeein the 1963 Annual
Reportofthe Board ofGovernors,pp. 48-49.                             sources of financing for Government securities dealers,
112                                                 MONTHLY REVIEW,JtJNE          l96

supply funds almost entirely through repurchase agree-                  ments can be arranged whenever the corporation has the
ments. In 1963, funds provided by corporations averaged                 funds. Finally, they may provide relatively attractive yields.
$1.5 billion a day, or 41 per cent of all financing of bank                Direct purchases of Treasury securities arc sometimes
and nonbank dealers, as shown in the table. To corpora-                 less desirable than repurchase agreements, because a cor-
tions, repurchase agreements with Government securities                 poration cannot always obtain a maturity date which fits
dealers are a liquid asset peculiarly adapted to certain of             its schedule of payments. To be sure, tax anticipation bills
their needs. To the dealers, repurchase agreements with                 —which can be turned in for payment of Federal income
corporations are a relatively cheap source of financing,                taxes—are usually available for March and June tax
which also provides their corporate customers with a de-                dates and occasionally also for September and December
sirable asset.                                                          tax dates; special bills maturing on the fifteenth of Jan-
   REASONS WHY CORPORATIONS MAKE REPURCHASE AGREE-                      uary, April, July, and October were available in the period
MEIS. Corporations hold cash and interest-bearing liquid                under review; and a new series of bills with month-end
assets for a number of reasons. First, they need cash or                maturities was introduced in August 1963. The regular
liquid assets that can readily be converted into cash to                weekly Treasury bills, however, mature only on Thurs-
meet income and other taxes, dividends, payrolls, and                   days. Furthermore, a corporation in need of an investment
other scheduled business expenditures. Since the timing                 outlet may not always be able to buy bills with desirable
and the approximate amount of many of these payments                    maturities at going rates in the secondary market.
are known well in advance, corporations can accumulate                     Finance company paper, another alternative short-term
assets in anticipation of the payments as income is earned.             investment, has some of the advantages of repurchase
Corporations may also accumulate liquid assets in periods               agreements. For example, the corporation can select the
when their net cash flow is large, thus building up a gen-              maturity date, within the range offered by the finance
eral liquidity reserve against unspecifiedneeds.7 Sometimes             companies. Moreover, corporations can obtain finance
the proceeds of bond or stock issues may be temporarily                 company paper wheneverwanted, since finance companies
invested in liquid assets until the funds are needed in the             prefer to regulate the volume of paper by adjusting their
business. In addition, interest rates may influencedecisions            rates rather than by refusing to sell paper. Also, the yields
to hold liquid assets in a numberof ways. For example,                  on finance company paper are higher than those on re-
relatively high interest rates may induce corporations to               purchase agreements except when finance companies are
hold more of their liquid assets in the form of earning as-             trying to discourage corporations from buying paper.
sets; interest rate differentials may influence their choice            There is, however, a modest increase in credit risk with
among earning assets; and expectations of rising rates may              finance company paper and, in contrast to repurchase
cause them to shorten maturities or increase cash holdings.             agreements, short maturities (less than five days) are
   Corporations may hold repurchase agreements for any                  seldom available.
of these reasons, but repurchase agreements have advan-                    Negotiable time certificates of deposit (C/D's), issued
tages over other assets which make them an especially                   by commercial banks, have been avaiLable since early
suitable form in which to accumulate funds for spcciflc                  1961 either on original issue or in the secondary market.
payments.B First, the maturity of the repurchase agree-                 The corporation can obtain any maturity date it wishes if
ment can be tailored to the corporation's payment sched-                the C/D is purchased on original issue from a bank, but
ule, thus eliminating the market risk implicit in holding               usually the rates have not been competitive with rates on
liquid assets that would have to be sold. This factor is                close substitutes on maturities under three months or at
especially attractive when a corporation expects prices of              times six months. Shorter C/D maturities can be pur-
money market assets to fall. Second, repurchase agree-                  chased in the secondary market at better yields, but the
                                                                        amounts available are usually limited and the desired
                                                                        maturity date may be unobtainable.
                                                                           That corporations do indeed use repurchase agreements
    In the 1950's, for example, corporationsbuilt up these liquidity
reservesin business recoveries whcn retainedearningsand deprecia-       as a means of accumulating funds to meet specific pay-
tion tended to exceed expenditures on inventories plant and
                                                    and                 ments is shown by the sharp decline in repurchase agree-
equipment. In the later stages of expansion and during recessions,
when capital expenditurestended to surpass retained earnings and        ments with corporations on the major tax and dividend
depreciationallowances, liquidassets were reducedto meet expendi-       dates and on other payment dates. Corporate repurchase
   8 should be recognized, however,that the                             agreements have also moved with sales of manufacturing
                                                 corporation assumes    corporations, probably reflecting the tendency for cor-
the creditrisk, remote though it may be, that the dealer will fail to
live up to his contract to repurchasethe securities.                    porateoutJays to vary with sales.
                                       FEDERAL RESERVE BANK OF NEW YORK                                              113

  TUE DRALERS' ATrITUDE TOWARD REPUROIASE             AGREE-   banks and other banks are considered as separate groups
MENTS WITH CORPORATIor. From the point          of   view of   of lenders. It should also be noted that the aggregatedata
the nonbank dealers the major advantage of short re-           on financingobtained from all New York Citybanks reflect
purchase agreements with corporations is, of course, thcir     by and large the behavior of those five banks which regu-
low cost, compared with loans from New York City banks.        larly make loans to nonhank dealers, and that of thedealer
Bank dealers may also at times find repurchase agree-          banks. (The latter groups partially overlap.)
ments with corpor4tions the cheapest or most acceptable           New York City banks alone provided dealers with a
source of funds.                                               daily average of $0.9 billion in 1963, as the table shows.
  In the case of long repurchase agreements, the cost is       Although this was a larger dollar volume than in 1961
sometimes less than the cost of day-to-day repurchase          and 1962, it represented approximately the same propor-
agreements and of collateral loans. In addition, long re-      tion of total dealer financing requirements as in those
purchase agreements with the privilege of substitution         years—roughly one quarter. The funds supplied by New
of collateral may be an especially attractive method of        York City banks included collateral loans to nonbank
financing when dealers expect day-to-day borrowing costs   dealers, a very small amount of repurchase agreements,
 to rise. There are also, however, long repurchase agree-  and funds allocated by the New York City dealer banks
ments that are not regarded as a financing method at all   to theirowndealerdepartments.
but rather as a transaction in which the dealer acquires      DEALER WANS AND RESERVE ADJuSTMENT. For com-
securities he would not otherwise hold in order to accom-  mercial banks, loans to nonbank Government securities
modate a customer who wishes to arrange a repurchase       dealers are an integral part of reserve management—the
agreement. In such a case, of course, the dealer expects   task of adjusting short—tcrin bank assets and liabilities to
 to make a profit on the spread between the yield on the   keep cash reserves at the desired or required levels. Mem-
securities and the rate he pays the customer.              ber banks of the Federal Reserve System must maintain
   In making long repurchase agreements the dealcr as-     a fixed pcrccntage of their time deposits and net demand
sumes a price risk, particularly if the repurchase agree-  deposits1' in the form of either vault cash or balances at
ment runs for several weeks or more, if the maturity of    their Federal Reserve Bank. These requirements have to be
the collateral appreciably exceeds that of the repurchase  covered on an average basis over a week for reserve city
agreement, and if substitution of collateral is not per-   banks and over two weeks for other banks. Since reserve
mitted. In such a case the dealer is unable to sell the    balances are constantly fluctuating, each bank must make
collateral should its price fall, so that a loss may be in-offsetting adjustments in short-term assets and liabilities
evitable. Dealers, therefore, prefer to have the right of  to restore the required or desired level of reserves. The
substitution of collateral in a long repurchase agreement, means most suitable for suchadjustments are Federal funds
which gives them the chance to shorten the maturity of      (balances at the Federal Reserve Banks), Treasury bills,
the underlying collateral if they see prices declining. Even
                                                           dealer loans, correspondent balances, and. if and when ap-
without the right of substitution, however, the dealers canpropriate. borrowingfrom the Federal Reserve Banks.
sell the securities for future delivery or sell short, thus   The choice among these alternatives will depend on
                                                           their relative costs, the length of time the surplus (Or
hedging against possible losses although at additional cost.
                                                           deficiency) is expected to last, the availability of the in-
                                                           struments, and the preference of the bank. The return on
                                                           dealer loans is frequently equal to, or higher than that of,
                    FINANCING FROM
        NEW YORK CITY COMMERCIAL BANKS                     other reserve adjustment media (usually with the excep-
                                                           tion of longer maturities of Treasury bills). For banks as
   The commercialbanking systemas a whole supplies well as for corporations. dealer loans have the merit of
the Government securities dealers with a larger volume being suitable for either one-day or longer term invest-
of funds than corporations, but the banking system is not ment. In contrast, the transactions cost of buying and
composed of a homogeneous group of lenders. The views selling Treasury bills—reflected in the dealers' spread
and actions of New York City banks in regard to dealer between bid and asked prices—discourages the use of
loans differ sharply from those of most banks outside New Treasury bills for very short-run adjustments, while the
York City, as do the characteristics of financing provided
by these two groups of banks. In addition, the impact of
dealer loans from banks on the money market is not the
same in the two cases. For these reasons, New York City and minus demanddeposil.c minuscash items in processofcollcction
                                                             D Grossdcmand
                                                                             balances at other domesticbanks.
114                                           MONTHLY REVIEW,JUNE 1964

costs of repeating paper work every day is a disadvantage       serve part of their financingfor New York City banks even
of using Federal funds for reserve adjustments lasting          if funds are readily available at lower costs elsewhere. In
several days. The possibilityof making dealer loans, how-       addition, as noted earlier, the transactions costs on col-
ever, may be limited when dealerpositions are low. More-        lateral loans at New York City banks are relatively low.
over, dealer loans arc usually limited, in practice, to the     Nevertheless, short-term money is usually available to the
larger banks because dealers naturally prefer arranging for     dealers outside the New York City banks at rates low
a smallnumberoflarge loans.                                     enough to compensate for the higher clearing costs and
    THE NEW YORK CITY BANKS' POLICIES TOWARD DEALER             lesser convenienceof such financing.
LOANS.  When the New York City banks that are active in            As a result, the normal procedure each morning is for
dealer financing seek to adjust their reserve positions         the nonbank dealers to borrow as much as possible of the
through dealer loans, they do it primarily by changing their    day's requirements (above a certain minimum) from
new and renewal dealer loan rates. After considering its        lenders other than New York City banks as long as costs
expected reserve position, the structure of money market        are below the rates charged by these banks. The residual
rates,and the dealers' probable needsfor loans, eachof the      is then financedat New York banks. Sometimes,of course,
five majorlending banks decides every morning whether to        the renewal rate or new loan rate of some of the New
encourage or discourage dealer loans. The dealerloan rate       York banks will be low enough to induce dealers to bor-
is set accordingly: when it is well above the expected Fed-     row from them early in the day without searching for
eral funds rate, for example, dealer loans will be dis-         other lenders. As a general rule, however, the New York
couraged. (The Federal funds rate represents the cost to        City banks are residual lenders to whom the dealers turn
the bank, if it has to borrow to finance the dealers, and the   when other lenders cannot provide enough money to
alternative yield it gives up in undertaking such financing;    finance a large increase in total borrowings or to offset
and it also approximates the rate the dealers pay on short-     periodic withdrawals of funds by corporations. The simi-
term repurchase agreements with otherlenders.)                  larity between movements in total dealer borrowing and
   Even if a bank has set rates that hopefully will discour-    borrowing from New York City banks is illustrated in the
age dealer loans, it stands ready to make loans at these        top panel of the chart on page 108, while the bottom panel
rates. Some of the New York Citybanksmay at times limit         shows that the share of dealer financing obtained from
the volume of loans they are preparedto make at posted          New York City banks has been high when reliance on
rates,but at least one bank is almost always willingto make     corporations has been low.
an unlimited volume of Federal funds loans at its posted
rates to the dealers as a group (while nevertheless limiting                  OTHER SOURCESOF FUNDS
the volume of loans to any one individual dealer—as banks
do with any borrower). The NewYorkCitybanks, in other             OTHER COMMERCIAL BANKS.         Banks outside New York
words, are willingto make dealerloans, even though such         City have also been a major source of funds for Govern-
loans may cause reserve deficits that have to bc offset by      ment securities dealers, supplying a daily average of
borrowing or by selling money market assets. A rise in          from $0.6 billion to $0.8 billion (20 to 23 per cent) of
dealer loans at the New York banks does, in fact, often         dealer financingin each of the lastthree years (1961-63).
result in an increase in their borrowings in the Federal        More than half of these funds were provided through re-
funds marketas reservelosses are offset.Similarly,a reduc-      purchase agreements, while the remainder represented
tion in dealer loans frequently has the opposite effect. In     funds allocated by the Chicago dealerbanksto their dealer
such cases, the five New York City banks thus accommo-          departments and collateral loans to nonbank dealers.
date dealers "at the expense" of theirown reservepositions,        The willingness of banks outside New York City to
although at rates profitable to themselves.                     supply funds to Government securities dealers depends
    NEW YORK CITY BANKS AS LENDERS OP LAST RESORT.       As     primarily on the reserve position of the banks and on the
a result, the New York City banks as a group have come          relative return on dealer loans. Those banks outside New
to serve as the lender of last resortfor Government securi-     York that make any dealer loans at all are usually adjust-
ties dealers. Collateral loans at New York City banks arc       ing their own positions (and hence may be termed
a  considerable convenience for the dealers, primarily          "adjusting" banks) because they change the volume of
because loans can be arranged even late in the day and          dealer loans in order to restore reserves to the desired level.
because collateral is easily recovered from these banks.        In contrast to New YorkCitybanks, these banks typically
Indeed, to facilitate cash trading—payment and delivery         do notaccommodate the dealers by increasing dealerloans
on the day the contract is concluded—most dealers re-           if they expect such an increase to force them to borrow
                                         FEDERAL RESERVE BANK OF NEW YORK                                                 115

ónore heavily. There are some out-of-town banks, how-            fixed payments, a temporary investment for the proceeds of
  ever, which do borrow in the Federal funds market to           a security issue, or a way of waiting out expected changes
   maintain a minimum level of dealer loans. With any            in interest rates. These considerations resemble those that
  given amount of short-tcrm surplus reserves, the volume        influence corporations.
   of dealer loans made by thesc banks will vary with the
  relative yield and availability of such loans, compared with
                                                                         THE IMPACT OF DEALER FINANCING
  other reserve adjustment media (as noted previously).                       ON THE MONEY MARKET
     As a result of the banks' attitudes toward dealer loans,
  combined with the dealers' readiness to borrow outside                                  of
                                                                    The characteristics the dealer financing mechanism
  New York, dealer financing from banks outside New              make it a primary channel for the daily redistribution of
  York has increased when the banks experienced tempo-           short-term funds throughout the economy and a majorlink
  rary reserve gains—for example, at midmonth when float         among the geographical and institutional sectors of the
  increases. In addition, funds supplied by banks outside        money market. Dealer financing results in heavy daily
  New York have increased when the dealers' borrowing            money market activity, since dealers change their positions
  requirements rose (see the top panel of the chart). At         —and hence their financing requirements—every day in
  such times the dealers intensified their efforts to locate     response to Treasury fInancings, Federal Reserve activity,
  banks outside New York City with surplus rcscrves, and         customers' needs, or their own appraisal of the market. In
  they probably paid the banks higher rates relative to          addition, becauseof the short average maturity of outstand-
  rates obtainable on other reserve adjustment media than        ing loans, either the dealers or the lenders can initiate a
  at other times.                                                heavy turnover of outstanding loans on any given day. The
     ThE FEDERAL RESERVE. The Federal Reserve,at its             fact that dealer financing activity is likely to redistribute
  own discretion, makes repurchase agreements available          funds among a wide variety of lenders clearly contributes
  to the nonbank Government securities dealers when the          to the important role of such financing in the money mar-
  System wants to prevent unduetightening of money market        ket. The dealers' sensitivity to costs, furthermore, insures
  conditions in periods of seasonal pressures or to satisfy      that thcy will take advantage of the short-term nawre of
   emporary reserve needs. In addition, the Federal Reserve      the loans and thediversity of the lenders to obtain low-cost
    as temporarily supplied somewhat longer term reserve         funds, thus making the money market as a whole a more
  needs through repurchase agreements on occasions when          sensitive tool for both borrowers and lenders.
  outright purchases of bills might have had a particularly         An illustration will help to show how dealer financing
  strong downward impact on rates. When dealers' inven-          redistributes bank reserves on a daily basis. If bank re-
  tories are low or funds are available elsewhere at lower       serves are flowing from the New York banks to those out-
  rates, however, the Federal Reserve may not be able to use     side the City, the New York City banks can post relatively
  repurchase agreements as it desires: dealers may not take      high rates on dealer loans, which encourage the dealers to
  the moneyoffered or may terminate the agreementspriorto        arrange new loans or refinance existing loans with oihcr
  maturity. On a daily averagc basis, the Fcdcral Reserve        lenders. If they succeed in arranging new financing outside
  supplies only a small part of dealers' needs. Such repur-      New York and are therefore able to repay loans at New
  chase agreements were at a record level in 1963 yet aver-      York City banks, a reflux of reserves into New York will
  aged only $114 million a day (3 per cent) of total dealer      be caused by dealeractivity.
  borrowing.                                                        The process by which the dealer loan mechanism helps
     OThERS. All lenders other than those discussed so far       spread the effects of Federal Reserve open market opera-
  supplied dealers with an average of $274 million a day         tions throughout the banking system is very similar. For
  in 1963, or slightly less than 8 per cent of their needs.      example, when the Federal Reserve sells Governments
  About one quarter of this financing took the form of           to the dealers to offset the usual midmonth expansion of
  collateral loans, which probably came mostly from New          bank reserves arising mainly from an increase in float,
  York agencies and branches of foreign banks. These             the dealers will have to finance these securities or resell
  agencies lend to Government securities dealers when they       them. Either action soaks up the excess funds that the
  have excess funds. Also in the category of other lenders       Federal Reserve was seeking to absorb and transmits the
  are state and local governments, insurance companies,          impact of the Federal Reserve's sales to banksthroughout
  and other financial institutions. For these lenders, dealer    the country. Furthermore, at this time the dealers may also
  loans may be an alternative to holding idle cash over a        refinance securities previously purchased with banks out-
  week end, a means of investing cash in anticipation of         side New York whichhold temporary reserve surpluses.
116                                        MONTHLY REVIEW,JUNE 1964

changes in the demand for dealer loans or in the supply
                                                         close attention to developments in dealer financing in
         dealer loans are a major outlet for excess funds,                                                      de-
                                                         ciding what actions are necessary to implement the policy
of funds seeking temporary investment heavily influence  directivesof the Federal Open MarketCommittee. Traders
closely related sectors of the money market, such as the at the Federal Reserve Bank of New York talk to the non-
markets for Federal funds and Treasury bills. A sharp    bank dealers frequently throughout the day to follow their
increase in dealers' positions, for example, may cause anprogress in meeting financing requirements. These reports
increase in the New York City banks'dealerloans even at  on the availabilityand cost of money from banks and other
                                                         lenders provide the Manager with one indication of the
higher lending rates, thus leading these banks to buy more
Federal funds and place upward pressure on the Federal   balance being struck in the money market between the de-
funds rate. And dealers who have unusual difficulty in   mand for bank reservesand the supply of them. Altogether,
finding financing may intensify their efforts to sell the scale of Government securities dealers' financing needs
Treasury bills, thus perhaps producing interest rate in- and the flexibility of theirfinancing arrangements make the
creases in this area.                                    dealer borrowing mechanism a factor of prime importancc
   The Manager of theSystem OpenMarketAccount gives in influencingand reflectingthe state of the money market.